Wednesday, August 19, 2015

Cochrane on the Equity Risk Premium and Macroeconomics

After reading some interesting discussions, I paused and wondered what two scholars who passed away over a decade might say. I’m thinking of Franco Modigliani and James Tobin but permit me to put that in context by noting a couple of interesting papers. John Cochrane commented on an interesting discussion of real returns to government bonds from the CEA while Stephen Williamson brought our attention to a discussion of real returns to capital by Paul Gomme, B. Ravikumar, and Peter Rupert:

The returns on all three Treasury securities have been declining and are currently low. The 5-year return, for instance, has been close to zero recently … pre- and post-tax real returns on (i) business capital and (ii) all capital have not been declining.5 The returns fell during the Great Recession, as they typically do in recessions. However, the returns quickly rebounded and are now as high as they have been over the past three decades! The after-tax return on business capital is more than 8 percent now, much larger than the pre-tax 5-year Treasury return. The after-tax return on all capital is more than 6 percent

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The authors present this evidence as a challenge to Larry Summer’s secular stagnation hypothesis:

While many authors have documented the low and declining returns on government debt, these returns bear little resemblance to the returns on productive capital: The latter is a direct measure and a much better indicator of adequate private investment opportunities and has been rising for the past five years. Summers (2014) and others have articulated the secular stagnation hypothesis based on insufficient aggregate demand: The evidence on investment strongly suggests otherwise. Indeed, the private sector has undertaken large capital outlays since the end of the recession. The takeaway here is that the current recovery is not an example of secular stagnation. The evidence on investment and returns on productive capital shatter the essential components of the secular stagnation hypothesis.

Before commenting on the macroeconomics here, let’s note Cochrane read what Williamson wrote and made the following two statements:

There is a risk premium, and it's big, and it varies over time. Practically all macro and growth theory forgets this fact.

I recently had some fun with the authors of DOW 36000 who wanted to pretend that the equity risk premium is zero. While Cochrane is certainly brighter than these two goofballs – I hope he does not think the current spread between the return to stocks and the return to bonds is a more appropriate measure of this risk premium. I tend to be a fan of Aswath Damodaran:

the historical equity risk premium for the US is between 2.73% to 8%, depending on the time period, risk free rate and averaging approach used. I will also cheerfully admit that I don't trust or use any of these numbers in my valuations…Using the framework described in the last section, I estimated an equity risk premium of 4.96% for the S&P 500 on January 1, 2014: During 2014, the S&P 500 climbed 11.39% during the year but also allowing for changes in cash flows, growth and the risk free rate, my update from January 1, 2015, yields an implied equity risk premium of 5.78%:

He has a lot more to say about his forward looking model of the equity risk premium. What is clear is that Damodaran would not argue that the 8% spread between the actual return to stocks and the actual return to bonds is an appropriate measure of expected returns and risk premia. But what frustrated me was how Cochrane dismissed the nation that macroeconomics ignores basic finance. Modigliani and Tobin were part of a team of economists who virtually invented modern financial economics. Which brings me to something else from this interesting paper not emphasized by Williamson:

the time series on private domestic nonresidential investment. Consistent with the pattern of the real return on productive capital, private domestic nonresidential investment has been steadily increasing since the end of the recent recession. The insert in the figure shows the deviations from trend and that private nonresidential investment is now more than 5 percent above trend. Private nonresidential investment is also 14.5 percent higher than its pre-recession peak in the fourth quarter of 2007.

I suspect Modigliani and Tobin would bring up Tobin’s Q in a tale that goes something like this. We saw both an increase in global savings and a collapse in investment demand which sent world economy into the tailspin Summers and Bernanke are noting. While both Keynesians would have argued for fiscal stimulus, we know most policymakers were doing just the opposite. So all we had left was monetary policy, which seems to be slowly working to reverse the Great Recession very much in the mode that their specifications of the Keynesian model would predict.

4 comments:

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